Financial regulators are getting dangerously comfortable

Ten years out from the Great Recession, the economy is looking relatively strong and stable. Last year, Congress rolled back certain parts of the Dodd-Frank Act, which put lots of new guardrails around Wall Street in 2010. And last week, regulators decided to weaken a few other rules. It seems American financial regulators are starting to relax and kick their feet up.

Unfortunately, this happy-go-lucky attitude could actually help bring on the next crisis.

A 20th-century economist named Hyman Minsky had a thesis about how current stability in the financial system almost inevitably breeds future instability. His work emphasized how the banking industry — its internal behavior and institutional culture — shapes the fate of the larger economy. Mainstream theory and modeling often ignores the banking industry, and instead treats the financial sector as just a passive intermediary — a point through which money moves to other places in the economy.

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But the banking industry creates and distributes credit. It chooses what investments should get that credit, and it decides how risky those investments can be. Minsky's point was that the further you get from a recession, the more the financial sector's appetite for risk increases. At first, the industry is cautious: The credit it gives out can be fully repaid with the income that can be reasonably expected from the investment in the near future. As the trauma of the recession becomes a distant memory, the financial sector becomes more reckless. Riskier bets are more profitable in the short-term. Banks and financial firms take on more bets where near-future returns can only cover interest, and eventually move into bets where those returns can't cover either.

Right now, the portion of investments that fit into that third category is higher than it's been in decades.

Eventually, we'll hit a "Minsky moment." Like Wile E. Coyote running in mid-air, the financial sector will look down and suddenly realize its dire situation. Its appetite for risk will shrink, perhaps even dramatically and violently, and everything will go downhill from there. The 2008 collapse of the housing bubble — and the massive expansion in completely unserviceable mortgages that led up to it — is a classic recent real-life example of this scenario.

This gets us back to the new deregulatory decisions by Congress and other regulators.

Minsky's basic point was about behavioral dynamics within the financial market: how the nature of the for-profit financial industry leads it into a cycle of risk-taking. But the people who participate in financial markets aren't just economic actors; they're political and social actors, too. They vote for politicians, donate to them, lobby them, call them up on the phone, and generally try to push them in particular directions. If the financial industry's economic hunger for risk goes up over the business cycle, then so does its political hunger for rules that allow for more risk taking. Stability breeds instability, through policymaking as well as markets.

The 2018 bank deregulation bill that Congress passed and President Trump signed did a few things. Most prominently, it changed the thresholds for what banks and financial institutions can designate as "systemically important." The label gets applied to firms that regulators think could threaten the whole system if they collapse. Getting the label means much tougher regulatory standards, so of course the banks would rather avoid it. Dodd-Frank set the threshold for who can get slapped with the label at $50 billion in assets. The 2018 law hiked that threshold to $250 billion, allowing around 25 of the country's 40 biggest banks — accounting for 20 percent of all the nation's banking assets — to escape the heightened scrutiny.

Most of the votes for the new bill, needless to say, came from Republicans, who are deeply sympathetic to the plight of Wall Street. But a fair number of centrist Democrats voted for the bill as well: around 30 in the House and 16 in the Senate. The most prominent of those Senate Democrats also got hundreds of thousands in donations from the financial industry.

The 2018 law also gave the Fed and regulators more leeway in how they design and implement rules that apply to the financial sector, and last week, regulators took advantage of that opportunity. The Financial Stability Oversight Council (FSOC) — a kind of roundtable of U.S. financial regulators — announced it would loosen the "systemically important" designation further and rely on a higher threshold of risk to decide who is "systemically important." It also said it will generally defer to the bank's primary regulator in making the call.

Finally, the Federal Reserve revealed some changes to the "stress tests" it performs on banks to see how they'd do in a theoretical crisis. For the portion of the tests that involve some subjective judgments about the banks' risk profile, the Fed won't give simple "pass" or "fail" grades anymore. The results of these tests have surprised Wall Street before, leading to sudden falls in a bank's stock, so the change certainly makes life a bit easier on the banks. But it arguably also makes things muddier for the public.

Taken on their own, these changes aren't catastrophic. The 2018 bank bill was more nerve-wracking. But taken as a trend, all these shifts point towards a regulatory culture and a policymaking attitude that's more and more lackadaisical about the risks that almost took down the U.S. economy in 2008. You'd think a period of economic calm and growth would be a vindication of the regulations that came before. Instead, it's being treated as a justification to roll those rules back.

Hyman Minsky, no doubt, is rolling over in his grave.